Believe those who are seeking the truth. Doubt those who find it.Andre Gide

Tuesday, September 3, 2013

U.S. price-level dynamics

Since some measure of "price-level stability" constitutes one half of the Fed's dual mandate, I thought it might be of some interest to document the behavior of various measures of the price-level and its components in the U.S. Some of what I report here will be familiar to some readers and maybe surprising to others. I conclude with a thought about NGDP targets and what they're supposed to accomplish over a price-level target.

Let me start with the consumer price index (CPI). The CPI is constructed by the Bureau of Labor Statistics. The CPI attempts to measure the dollar cost of a typical basket of consumer goods and services (to see which goods and service are included, click here).

The following figure plots the CPI, core CPI, food, and energy. The core CPI is defined as "all items excluding food and energy."

The two striking properties of this data are: (1) consumer goods and services prices (measured in dollars) have generally been rising, with an exceptionally rapid rise occurring in the 1970s; and (2) the dollar price of energy is relatively volatile, with its trend diverging from the other CPI components for a considerable length of time.

When people speak of "high inflation" these days, I think they are generally focused on the recent behavior of food and energy prices. As the diagram above shows, energy prices have increased by about 150% since 2000. Food prices have generally risen more rapidly than other CPI components since 2009, but only modestly so. But it's important to keep in mind that while food and energy are obviously important, together they account for only 25% of expenditures on consumer goods and services (in the CPI basket).

While many people appear to be focused on the rapid rise in energy prices, the data above suggest that it might be more interesting to ask why energy prices remained so low throughout much of the 1980s and 1990s. Economists like to stress the role of relative prices in coordinating the allocation of resources in an economy. The price of energy relative to other consumer goods and services fell significantly over the time period 1984-1999, and caught up with the rest of the basket only in 2004.

Why was energy so cheap from 1984-2004 and what implications (if any) did this have for resource allocation?

The next diagram plots the same data, but using a log scale. Transforming the data in this manner is convenient because the slopes of the curves can be interpreted as inflation rates.

This diagram highlights the effect of the energy price shocks that occurred in the early and late 1970s. The sharp spike in energy prices that occurred in 2008 is relatively small by comparison.

Let's take a look at the (log) CPI from 1990 onward and draw a linear trend line through the data. Here is what we get:

The CPI inflation rate since 1990 averaged 2.62% per annum. The current CPI inflation rate appears to be close to trend.

Of course, the Fed's official target of 2% inflation refers not to CPI inflation, but to the PCE inflation rate. PCE stands for "Personal Consumption Expenditures" price index; see here. The following diagram plots the PCE price index from 1959 onward, and decomposes the PCE into (1) durable goods, (2) nondurable goods, and (3) services.

It's interesting to see the price deflation in consumer durables since the early 1990s. The volatility in nondurable goods near the end of the sample is likely attributable to energy prices.

Now let's take a look at the (log) PCE from 1990 onward, together with linear trend:

The PCE inflation rate since 1990 averaged 2.09% per annum.

What's interesting about this diagram is that even though the Fed does not officially target the PCE price level, the data above suggests that the Fed is behaving as if it does.

As a price-level (PL) target is equivalent to a nominal GDP (NGDP) target in a wide class of macroeconomic models (especially under the assumption of constant productivity growth), then what more does the NGDP crowd expect from an official NGDP target? Seems to me that they are just asking for more price inflation and wishfully hoping that some of the subsequent rise in NGDP will take the form of real income.

17 comments:

David Andolfatto:"As a price-level (PL) target is equivalent to a nominal GDP (NGDP) target in a wide class of macroeconomic models (especially under the assumption of constant productivity growth), then what more does the NGDP crowd expect from an official NGDP target?"

Hall and Mankiw compare three different versions of nominal income targeting and conclude by saying:

"Although nominal income targeting is no panacea, it is a reasonably good rule for the conduct of monetary policy. Simulations of a simple macro model suggest that, compared to historical policy, the primary benefit of nominal income targeting is reduced volatility in the price level and the inflation rate. Under conservative assumptions, real economic activity would be about as volatile as it has been over the past forty years. If the elimination of spontaneous shifts in monetary policy improves forecasts markedly, real activity could be much less volatile.

We have discussed various ways in which a central bank might formulate a nominal income target. We have emphasized three in particular, which we call growth rate targeting, level targeting, and hybrid targeting. Our calculations indicate that none of these policies clearly dominates the others, although growth rate targeting seems to yield the least desirable outcomes. Which targeting scheme a central bank should adopt depends on the relative costs of volatility in price levels, inflation rates, real income levels, and real income growth rates. These are topics on which more research is needed.

Our discussion has stayed within the domain of nominal income targets, guided by the principle of simplicity. But our results suggest that, if the monetary authorities will consider a slightly more complicated policy, one that looks primarily at the level of real activity and secondarily at the level of prices, they can achieve a considerably more appealing combination of output and price stability."

So, in short, Hall and Mankiw state that optimum monetary policy takes into account not only the price level, but *also* the level of real economic activity. And moreover, they conclude that nominal income targeting could be improved upon by a policy that places *greater weight* on real economic activity than the price level.

And in an interview with Dylan Matthews in September 2012, a couple of weeks after his Jackson Hole speech, Woodford stated that he believed the optimum policy is in fact an Output Gap Adjusted Price Level Target (OGAPLT):

An OGAPLT is a corrected PLT where some multiple of the real output gap is added to it. Woodford prefers this modification of PLT because he thinks it is important to also take into account the level of real economic activity. But he also pointed out that NGDP Level Targeting (NGDPLT) is more practical, and is nearly as ideal as OGAPLT. That's why he spoke about NGDPLT at length in his speech at Jackson Hole:

I suppose when I said "a wide class of models," I was hoping that someone would point me to a "modern" macro model for which the the two policies had very different implications. I attempted to do so here:http://andolfatto.blogspot.com/2012/06/ngdp-targeting-in-olg-model-another-try.htmlWhat I found was PL target seems to dominate NGDP target and, importantly, I go to some trouble to explain the basic intuition in simple terms.

I do not see any real "model" in the Hall and Mankiw paper (I do not consider a reduced form inflation expectation augmented Phillips curve a full model, but maybe I should?)

As for Woodford's OGAPLT idea, I confess to not having got around to reading that yet. Would you, or anyone else, care to explain the basic idea in simple terms? I just wonder why it appears to difficult to explain the logic of NGDP targeting (over PLT) in a simple, persuasive manner?

David Andolfatto:"Seems to me that they are just asking for more price inflation and wishfully hoping that some of the subsequent rise in NGDP will take the form of real income."

If we there was a reduction in U.S. potential output that undermines that case for looking at NGDP being below trend, and the Fed has done a fine job with monetary conditions, then why is the demand for safe assets still so pronounced?

Here are five facts about this ongoing demand for liquidity (with apologies to David Beckworth):

Fact 1Households and businesses have increased their holdings of currency, checkable deposits and saving deposits at an usually rapid rate. This surge started during the recession and is still growing:

Since November 2007 households and businesses increased their holdings of currency, checkable deposits and savings deposits from $5310 billion to $9590 billion or by 80.6%.

Fact 2Households have been one of the biggest purchasers of U.S. Treasuries over the past 5 years. This is even more than the Fed's increase in Treasury holdings and only foreigners have bought more.

Household holdings went from $183 billion in 2007Q4 to $1,229 billion in 2013Q1. Including mutual fund purchasers household holdings rose from $565 billion in 2007Q4 to $2,239 billion in 2013Q1. In comparison the Fed's holdings only have increased from $741 billion in 2007Q4 to $1779 billion in 2013Q1. Interestingly, the Fed's holdings have only risen from 14.6% of all marketable Treasuries in 2007Q4 to 15.0% of all marketable Treasuries in 2013Q1:

http://www.sifma.org/research/statistics.aspx

Fact 3Household holdings of liquid assets as a percent of total assets soared from just over 9% before the recession to over 12% in 2008Q4 and have remained at this level ever since:

Given the facts above, it should be evident that these low interest rates are the result of an elevated demand for safe assets. And recall the biggest purchasers of U.S. Treasuries has not been the Fed over the past five years.

Fact 5Since the recession movements in the stock market and expected inflation have been highly correlated:

This is an unusual relationship that only started during the recession and only began to weaken this year. The interpretation that is most consistent with these facts is that the surge in demand for safe, liquid assets that began in the recession still has yet to subside. Any increase in expected inflation that reduces the demand for liquid assets and therefore increases nominal income expectations, also raises expected stock prices. In anticipation of this investors buy stocks in the present:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1749062

Thus, expected inflation and stock prices have been closely related since the recession. Since liquidity demand still remains elevated, there apparently has not been a big enough increase nominal income expectations to break this relationship.

These facts indicate there is still an elevated demand for liquidity that is slowing the economy. By changing nominal income expectations the Fed could reduce this demand for liquidity and spark a recovery in nominal spending. By setting an NGDP level target, the Fed could increase nominal income expectations. This would increase demand for credit and consequently increase the rate of creation of safe private assets. It would also decrease the demand for safe assets.

If we there was a reduction in U.S. potential output that undermines that case for looking at NGDP being below trend, and the Fed has done a fine job with monetary conditions, then why is the demand for safe assets still so pronounced?

I wasn't aware that the Fed could determine the world demand for safe assets. The world supply of safe assets is currently largely determined by the U.S. Treasury. When the Fed removes these Treasuries from the public and replaces them with interest-bearing reserves, I fail to see how the net supply of safe assets has changed.

These facts indicate there is still an elevated demand for liquidity that is slowing the economy. By changing nominal income expectations the Fed could reduce this demand for liquidity and spark a recovery in nominal spending. By setting an NGDP level target, the Fed could increase nominal income expectations. This would increase demand for credit and consequently increase the rate of creation of safe private assets. It would also decrease the demand for safe assets.

What you fail to explain is the cause of the elevated demand for liquidity. Do you view it as exogenous and socially irrational? If so, then just come out and say it. And then yes, of course, a benevolent intervention may correct the problem. (Whether this power lies with the Fed or the Treasury remains open for debate, however.)

Not only is the US a significant source of the supply for safe assets, it is a significaant source of the demand for safe assets. Furthermore:

1) Historically the supply of U.S. private safe assets has been significantly larger than the stock of U.S. government safe assets.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1986945

2) Consequently it is unlikely that the U.S. Treasury could create enough securities to fill the gap created by the shortage of private safe assets without undermining the safe asset status of Treasuries.

3) Historically a sudden and permanent rise in the expected growth of NGDP leads to a rise in the supply of private safe assets and a decline of public safe assets.

http://fmwww.bc.edu/ec-p/wp802.pdf

http://people.wku.edu/david.beckworth/irfsblog.pdf

4) The resolution to the safe asset shortage problem, then, is monetary policy catalyzing the private sector into recovery.

The global shortage of safe assets is related to the shortfall in NGDP in much of the advanced world since 2008.

I don't think you're wrong, as we've both worked through similar models of NGDP v. PL targeting. I just want to point out that one's definition of the price level is critical for the empirical analysis. I wrote a paper (now in Economics Letters, 2012) showing that the answer to the question "does inflation affect stock returns" is sensitive to the measure of inflation employed. So, from an empirical standpoint, we'd have to be careful as to what PL measure was being used as the target. I think you do a nice job of illustrating the issue here, just wanted to buttress the argument.

In practice, the Fed would not have tightened in response to a sharp increase in energy prices because energy prices are highly volatile and considered to be transitory. That is why the Fed favors trend measures of inflation, like "core PCE" which excludes food and energy prices.

When you say "...the Fed does not officially target the PCE price level," do you mean that the Fed targets the rate (i.e.: "Of course, the Fed's official target of 2% inflation refers not to CPI inflation, but to the PCE inflation rate.")? If so, could you explain why that distinction is is clear from the data?

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